An ETF Must Have a Code

An ETF Must Have a Code

The Bunk said it best when he told Omar “a man must have a code”, and two decades before I took up the battle against market cap weighted portfolios I was writing pseudonymous posts about baseball statistics with my “code” focused on the critical missions of getting intentional walks excluded from advanced baseball metrics, and how to normalize opposing pitchers faced for pitcher evaluations in fantasy baseball (less an AL/NL issue than a SP/RP issue, it turned out). A man must have a code.

Khris Davis is a .247 hitter. We all love round numbers, but it would be incorrect to call him a .250 hitter. Khris Davis is a .247 hitter. He hit .247 in 2015. Then he hit .247 in 2016. Then he hit .247 in 2017. Then he hit .247 in 2018.

How unusual is that? Well, just as having a friend with a boat is infinitely more fun than owning your own boat, knowing people who are math geniuses is a lot easier than being one. So I emailed legendary quant Aaron Brown and received this response:

It’s not as unlikely as it might seem. There have been 15,091 pairs of successive seasons (not counting the 2018 season) where a major league batter had at least 300 at bats in both. In 177 of those, 1.17%, the batter had the same batting average rounded to three decimal places in both seasons. If you assume these events are independent from year-to-year, then you estimate the probability of a particular player doing it three years in a row (that is, four seasons total) at 1.17% cubed or about 1 in 620,000. The chance of that happening sometime in baseball history is about 1 in 40.

That’s likely an underestimate of the probability, because a player hitting the same average two years in a row suggests the average is near his mode, and also that he’s reasonably consistent.

If accomplishing the feat were independent, you would expect 6.8 players would have done it twice. Six have done it, suggesting it’s not too far from independent, despite the arguments in the paragraph above.

To a stat nerd like myself, the Khris Davis .247 streak is magical. And like the protagonist in the film Pi, I spent an hour reading Khris Davis stat lines seeing “247”s everywhere. For example: the square root of .247 is .497. Davis has 497 career RBI in MLB. .247 squared is .061. Davis has 61 career RBI in AAA. Seriously. I can do this all day.

Real life, of course, is less orderly and often less magical. Chris Davis has no relation to Khris Davis, and coming into the 2015 season Chris was not only the better speller but also the better hitter. That year – 2015 – Khris Davis hit .247 while Chris Davis hit .262, along with 47 home runs and a 14thplace showing in the MVP voting. And after that, as Khris Davis continued to hit .247, Chris Davis hit .221, .215 and .168 in succession. This year, when Chris Davis hit .168, that came along with a historically poor on base percentage of .243 and a slugging of .296. He was paid $23 million for that “production”, as he will be every year through 2022. His team, the Baltimore Orioles, lost 115 games and were the worst team in baseball by far.

The baseball gods are cruel. The stock market gods just might be even crueler.

In the 21 years prior to our launch of the reverse cap us large cap index, from 1997-2017, an equal weight version of the S&P 500 beat the market cap weight version of the S&P 500 13 times (62%). Those are pretty good odds. But good odds are no guarantee.

I tend to think of the cap/equal/reverse relationship as a see-saw. Equal weight is perfectly balanced. Equal weight is the fulcrum in the middle. The two ends of the see-saw are cap weight and reverse cap weight. In periods where cap outperforms equal, equal tends to outperform reverse. And in periods where equal outperforms cap, reverse tends to outperform them all. And equal has outperformed cap more often than not.

We have seen behavioral science findings applied to the field of investing in recent years, which has helped advisors and their clients understand and avoid countless biases and mistakes. Dan Egan is a leader in applied behavioral sciences and wrote about how an investor without a faith is doomed. The post was extremely insightful, and focused on staying with a portfolio, a strategy and a plan even when you might be tempted to change course. To use Dan’s own words:

“An investor without a faith is doomed… [Strategies] all have periods where they look best, and periods where they under-perform.

Except if you don’t stick with it. Except if you flop in and out of strategies with each glittering fad and temporary disappointment.”

Having unwavering faith in a strategy, rooted in empirical data and a thesis that makes sense to you, is a vital part of being a good investor. Khris Davis won’t hit .247 next year, and the strategy that should provide 2% alpha will not provide 2% alpha – it might underperform and it might exceed your modest expectations. But if you don’t stick with your process you deny yourself the potential to be there when the ship comes in. You are assured of eating the bad years and missing out on the good years.

We have unwavering faith in our ETFs, which is to say, within historical probabilities and tolerances, we expect them to do what they are designed to do. These funds will be around in a hundred years, long after I am gone, doing what they do. They were built for a reason and they were built to last.

An investor without a faith is doomed, and an ETF issuer without faith is doomed. An investor without a code is doomed.